How to Solve the ‘Equity Dilemma’

So how can they balance the need to
keep an equity allocation high enough to ensure participants have enough
retirement savings, with the need to keep the allocation low enough that they
have greater protection from market risk? The answer is a low-volatility
strategy in a portfolio’s equity sleeve, Mike Raso, senior vice president and
director of institutional retirement at Old Mutual Asset Management, told PLANADVISER.

This strategy offers both downside
protection and upside participation for investors, Raso said. Greater downside
protection, especially near the end of a participant’s accumulation cycle, must
be built into the equity sleeves of retirement plans to avoid a repeat of the
2008 financial disaster’s effect on retirees, according to Old Mutual’s paper,
“The Target Date Equity Dilemma.”

While plan sponsors cannot control
the contributions and time components, they can control investment volatility,
which is why target-date funds (TDFs) are ideal beneficiaries of a
low-volatility strategy, the paper explains. It outlines three main approaches
to lowering the volatility of an equity sleeve in the TDF:

Utilizing defensively oriented value managers;

Hiring managers who use a quantitative approach to
produce a portfolio designed to have the lowest expected volatility for a
given set of constraints; and

Utilizing alternatives (such as commodities, managed
futures, real estate and hedging strategies) in conjunction with
traditional equity strategies to smooth returns and create a
low-volatility effect. “We’re really starting to see real estate
make its way into customized TDFs,” Raso said. “Commodities are making
their way, too.”

(Cont’d…)

Traditionally, alternatives have
been the first approach to lower a portfolio’s volatility, but they come with a
higher price and can have liquidity constraints in a TDF structure, according
to the paper. The development of systematic portfolios focused on lower
volatility, as well as defensively oriented managers, have become popular,
lower-cost options to solve the volatility problem, the paper said.

Raso said customized TDFs,
traditionally seen in large and mega plans, are beginning to “come downstream”
to smaller plans. “I think everyone can benefit from them,” he added.

Although cost is still a hindrance
for smaller plans to adopt custom TDFs, Raso said he thinks they will become
more cost efficient as a result of fees being compressed following the passage
of regulations like 404(a)(5) and 408(b)(2).

Creating customized TDFs allows plan
sponsors to cater to their specific participant demographic. Selectively
implementing de-risking and/or risk-budgeting through low-volatility strategies
will empower sponsors to create better solutions for their plan participants
and help them fulfill their fiduciary duties, the paper concluded.